What to do if you’ve Contributed Too Much to an IRA

It’s hard to believe, but we’re only a few weeks away from the end of tax season. Those of you that haven’t filed yet are likely feeling pressure. You need to get your return done, but you may also find yourself in some last minute dilemmas.

Consider what happened to one of my clients, who got married last year. Filing jointly for the first time, he discovered that he and his husband’s combined income exceeded Roth IRA limits.

I offered him a few solutions that I thought you may find useful as well.

Know the Limits

Most tax-favored investment vehicles are gradually reduced, then eliminated, as incomes rise, unless you are not covered by an employer plan. In other words, if you don’t have access to a retirement plan at work, you can contribute to an IRA no matter what your income.

If you happen to be an IRA contributor who is not covered by a workplace retirement plan but are married to someone who is covered, the deduction is phased out if the couple’s income is between $184,000 and $194,000, if you file jointly. If you file MFS, the phase out is between $0 and $10,000. Yet another reason not to file separately from your spouse.

For 2016, if you participate in a company sponsored retirement plan, your ability to deduct your traditional IRA contribution is phased out if:

As a single filer or head of household, you make between $61,000 and $71,000 of modified adjusted gross income (MAGI). If you earn above $71,000, you don’t get to deduct anything.

If you’re married and file jointly with your spouse, and you make between $98,000 and $118,000 of MAGI. Earn over $118,000, and you get no deduction at all.

For a married individual filing a separate return, the phase-out range is $0 to $10,000.

Lastly, for Roth IRA contributors, the MAGI phase-out ranges are as follows:

Single Filers and Head of Household: $117,000 to $132,000.

Married Filing Jointly: $184,000 to $194,000.

Married Filing Separate: $0 to $10,000.

The penalty for contributing too much to an IRA is a 6% excise tax that applies to any excess contributions.

Solution #1 – Withdrawal Your Excess Contributions

Some people have trouble predicting how much they’ll make each year, either because their earnings fluctuate or a big chunk of their pay comes in year-end bonuses. As a result, it’s easy to end up contributing too much if your income rises unexpectedly. If you find you’ve contributed too much based on your income (or for whatever reason), you can simply withdraw your contributions by the due date of your tax return, including extensions. You also have to withdrawal any earnings that you made on those contributions as well.

Solution #2 – Apply Excess Contributions to a Future Year

You can also apply your excess contributions to a future year, if the amount you apply is less than the limit for the next year. For example, if you realize you have exceeded the income limits for 2016 and want apply your excess contributions to 2017 you can do so as long as the excess contributions are below $5,500 ($6,500 if 50 or over).

Solution #3 – Recharacterize Your Contributions

Lastly you can “recharacterize” or reclassify your contributions as a traditional IRA (assuming you qualify), Roth IRA or a non-deductible IRA, whichever applies. It’s best to do this by contacting your administrator. They can then perform a trustee-to-trustee rollover, so you don’t have any unintended consequences of taking money out of your account.

With this solution, you may still be able to contribute to a Roth IRA by sneaking in the “back door.”

In order to do this, you can make a non-deductible contribution to a traditional IRA and then covert that money into a Roth. There are no income limits to converting, and you’ve already paid taxes on the non-deductible contribution, so you won’t have to pay taxes again. The best part is that you get the benefit of tax-free growth.

(Side note: If you don’t convert right away, you risk having to pay tax on any growth earned between the initial investment and the time of conversion.)

The big caveat here is to only do this if you don’t already have a lot of money in traditional IRAs. With any conversions, all earnings and previously untaxed contributions in traditional IRAs are taxed on a pro-rata basis. In short, you can’t just pay tax on the amount converted, you have to take into account all previously untaxed contributions and earnings. You definitely want to see a tax advisor if you fall into this category to figure out what kind of tax bill you’ll face when you convert.

I hope this was helpful in dealing with any IRA contribution issues with the upcoming filing deadline. For additional information on everything IRA, see IRS Publication 590-A and IRS Publication 590-B. Feel free to email, message or tweet me with any questions or comments.

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Brian Thompson Financial LLC (“BTF”), is a Registered investment Adviser in the State of Illinois. Based in Chicago, BTF focuses specifically on serving the LGBTQ community locally and nationwide. Brian Thompson, JD, CFP® is a proud member of NAPFA, XY Planning Network and Pride Planners.